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July 30, 2010

State Bank raises policy rate by 50 bps to 13.0%

The State Bank of Pakistan has decided to raise the policy rate by 50 basis points

to 13.0 percent with effect from August 2nd, 2010. This was announced by Mr. Yaseen

Anwar, Acting Governor, State Bank of Pakistan, while unveiling the Monetary Policy

Statement at a press conference held at SBP, Karachi today.

“This has been done to mitigate risks to macroeconomic stability, monetary

policy has to take lead for containing aggregate demand pressures emanating mainly

from expansionary fiscal position,” Mr. Anwar explained the rationale behind raising the

policy rate. He said that renewed committed efforts are required to increase the

economy’s resource envelope and contain current expenditures. In particular, measures

to increase the tax to GDP ratio and eliminate the revenue deficit of fiscal accounts are

urgently required to provide a firm foundation for sustainable economic growth. “This

would reduce the pressure on government borrowings from SBP and debt payments,

create room for development expenditures in critical areas, and soften the adverse

impact on the private sector,” he added.

He said that the average CPI inflation of 11.7 percent during FY10 has been 2.7

percentage points higher than the target and current trends and expected

developments indicate risks of inflation pressures continuing in the current 2010-2011fiscal year (FY11). These include further upward adjustments in electricity prices,

increase in General Sales Tax (GST), and revisions in government employees’ wages to

compensate for the current high inflation, he said and added that after incorporating

these factors, the average CPI inflation is projected to remain between 11 and 12

percent in FY11, which is higher than the announced target of 9.5 percent.

Mr. Anwar said with the start of new fiscal year concerns of persistence in

inflation and fiscal weaknesses are overshadowing the improvement in the external

current account deficit and economic recovery. He said that the gap between national

savings and investment has narrowed but mainly because of decline in investments and

at the same time aggregate domestic demand, led by public sector consumption

expenditures, is picking up while prospects of aggregate supply remain weak due to

energy shortages and dismal law and order conditions. “These developments together



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with rising total debt are stressing the macroeconomic stability and call for renewed

efforts to maintain an upward trajectory in economic growth,” he asserted.

He said an increase in the Net Domestic Assets (NDA) of the banking system of

Rs 488 billion during FY10 can be largely explained by the government’s borrowingrequirements for budgetary support and commodity operations. “The need for

continued reliance on the banking system, both from scheduled banks and SBP, to

finance the fiscal deficit essentially emanates from low tax revenues, high current

expenditures, and shortfalls in projected external financing,” he said and added that tax

collection by the FBR at Rs 1,327 billion shows a shortfall of Rs 53 billion the target of Rs

1,380 billion for the year, while only Rs 177 billion was received from external sources

against the budget estimate of Rs377 billion.

The SBP Acting Governor said the provisional figures indicate that the revisedFY10 fiscal deficit target of 5.1 percent has been missed and could be higher than 6.0

percent. Similarly, the target of government borrowings from SBP has also been

breached for the fourth quarter of FY10 as the stock of net government borrowings

from SBP (on cash basis) was at Rs 1,171 billion as on June 30th

, 2010 against the target

of Rs 1,130 billion. Clearly, such fiscal developments are inconsistent with the objectives

of macroeconomic stability, he said and added that these have contributed towards

aggravating expectations of rising inflation and have kept an upward pressure on

interest rates. The result is a crowding out of private sector credit and increased stress

on debt sustainability, he added.

“Containing the fiscal deficit within the announced target of 4 percent of GDP for

FY11 already seems challenging,” Mr. Anwar said. Moreover, meeting the tax collection

target of Rs 1,667 billion would require a 25.6 percent growth or a 0.8 percentage point

improvement in the tax to GDP ratio, which seems unlikely without broadening of the

tax base, he said and added that low tax revenues of the government have become a

serious concern as it has increased reliance on foreign borrowings to meet rising

expenditures. “Delays or shortfalls in such inflows could put pressure on externalaccounts sustainability,” he observed.

Talking about external sector, Mr. Anwar said the current account deficit of $3.5

billion or 2 percent of GDP during FY10 was below earlier projections despite steady

acceleration in imports in the second half. Notwithstanding significantly lower Foreign



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Direct Investments (FDI) and shortfalls in projected foreign inflows, SBP’s foreign

exchange reserves increased to $13 billion by end-June 2010 from $9.1 billion at end-

June 2009, he added. “This includes receipts of $4.6 billion from the IMF; $2.2 billion for

balance of payment support, $1.1 billion for temporary bridge financing for the budget,

and $1.3 billion through a onetime non-recurring increase in SDR allocations,” he added.

Mr. Anwar said that the Net Foreign Assets (NFA) of the banking system

increased by Rs152 billion during FY10 due to an improvement in the balance of

payment position. “This, together with increases in total deposits of the banking system,

has facilitated the market liquidity conditions and helped in meeting the credit

requirements of the economy,” he added.

He, however, said that the sustainability of external accounts improvement and

build up of NFA face headwinds in FY11. “Consistent with recovery in the domesticeconomy and forecasts of higher international commodity prices, import growth is

projected to increase to 12.0 percent in FY11 as opposed to a decline of 2.3 percent in

FY10,” he said and added that despite the uncertainty of economic recovery in

Pakistan’s export destination countries and an unfavorable domestic business

environment, the export growth for FY11 is projected to be around 7.0 percent

compared to 2.7 percent recorded in FY10. “After assuming a benign outlook for

worker’s remittances and further CSF (Coalition Support Fund) inflows, this trade

outlook is expected to widen the external current account to 3.7 percent of projected

GDP,” he added.

SBP Acting Governor said while incorporating the projections of the external

sector and consolidated fiscal position along with the announced targets of inflation and

real GDP growth, the broad money is projected to grow by 13.0 percent in FY11. The

total investment as a percent of GDP has now declined for three consecutive years,

reaching 16.6 percent in FY10, he said. “Supported by an increase in workers’

remittances, national savings on the other hand, improved by 0.5 percentage points to

13.8 percent of GDP in FY10,” he added.

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